Do you know how your self-employment income qualifies you for a home loan? Unless you work with an expert in this area, it can be a daunting process. Below, we discuss what to consider before applying for a home loan.
With self-employment income, it’s critical to understand how you receive this income and how you’ve structured your business entity. The three most commonly used entity structures for self-employed borrowers are Sole Proprietorships, Limited Liability Corporations (LLC), and S Corporations.
Each has different tax implications, so be sure to consult your tax professional before making any decisions. If you are a Sole Proprietor, you will prepare form Schedule–C on your personal tax return. If you are working under an LLC or S Corp, you will file business returns, receive a K1, and in some cases with an S Corp, also a W-2. These are the documents your lender will review when considering your eligibility for home financing. Next, we’ll explain how each of these will be evaluated.
How Do You Receive Self-Employment Income?
- Sole Proprietorship – Schedule C
- Limited Liability Corporation (LLC)
- S Corporation
How Is My Self-Employment Income Calculated?
When a lender looks at the income you earn from self-employment, they will not simply look at your company’s revenue. Lenders are more focused on the net income you derive from your business.
If your company earns $600k of total revenue and you are offsetting this revenue with $400k of company expenses, your net income, in this case, would be $200k. This is the amount that would be considered your qualifying income for your home financing, pending any add backs.
By add backs, we mean if you have $400k of expenses, some of those write-offs can be added back to increase your qualifying income. The two most common add backs are home office expenses and depreciation related to business equipment or company owned real estate.
For example, the IRS allows business owners to spread the cost of large equipment, meaning if you purchase a big machine to make your widgets at a cost of $100k, and the useful life of that machine is five years, the IRS allows you to spread the expense $20k per year for five years. Because the expense in the subsequent years didn’t affect the cash flow of the business, lenders allow it to be added back.
How Will My Situation Be Evaluated?
Lenders first evaluate how your business is performing over time: is it growing, maintaining, or declining? If your income declined over the past two years, your lender will use the lower income amount earned in the most recent year; conversely, if your income increased over the past two years, your lender will take the average of the past two years.
For example, if your net income in 2016 was $100k and your net income in 2017 was $200k, the lender will average the two years and use $150k as your qualifying income. Conversely, if your net income in 2016 was $200k and your net income in 2017 was $100k, the lender will use the declining amount of $100k as your qualifying income.
It’s important to note that when your income is, in fact, declining the lender will dig a little deeper to determine that your business is not continuing to decline in the current year. You should be prepared to have your accountant provide year-to-date financials for your company supporting that things are level or back on the upswing.
Secondly, your lender will need to verify that you have owned your business for at least two years and that your income is likely to continue at your current earning level for at least the next three years. Keep in mind, it’s more difficult to gain a financing approval when your business earnings are declining year-over-year. Be very clear with your lender about both the current and future state of your business.
Although these are general guidelines, there are exceptions to these rules as lenders understand that every situation is unique. Certain situations causing declining income can be both explained and supported.
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When obtaining home financing with self-employed income, it’s best to prepare for your submission and get started early. We recommend organizing the last two years of tax returns, both personal and business, and keep handy any K1s received during that time, along with any other supporting documentation that may be helpful to provide to your lender while they are evaluating your eligibility.
Often, we find that self-employed borrowers qualify for less than they expect due to a fluctuation of income and the significant amount of write-offs taken to minimize one’s tax liability. But the real key is working with a lender who specializes in this area so you know where you stand, and not find out weeks into a transaction when you’ve already committed to a home you love.